As we hope you all know, any time a real estate developer or issuer takes money from a person or entity that will not be an active participate in the efforts to make the endeavor profitable, then that money raised is a security and the issuer must comply with securities laws. Some of those laws relate to the sale of securities only to people who are knowledgeable enough and satisfy certain requirements to bear the economic risk of the investment. Those investors are referred to as “accredited investors”.
The U.S. Securities and Exchange Commission (SEC) recently adopted amendments to Rule 501(a) of Regulation D promulgated under the Securities Act of 1933, as amended (Securities Act), which expand the definition of “accredited investor” (Final Rule). The Final Rule permits a greater number of investors to participate in private offerings by, among other things, extending the definition of accredited investor to include knowledgeable employees and certain licensed professionals and broadening the accredited investor definition with respect to certain entities, such as family offices and limited liability companies.
The current definition of “accredited investor” has been in place since the 1980s with several amendments. The stated purpose of Final Rule is to “update and improve the definition to more effectively identify institutional and individual investors that have the knowledge and expertise to participate in those markets.” The Final Rule will allow individuals and entities to participate in private capital markets based on established, clear measures of financial sophistication in additional to income or net worth.
This Final Rule aids in closing the gap in the accredited investor definition that historically has either prevented otherwise qualified institutional investors from participating in private placements under Regulation D, or required the issuer to prepare an additional disclosure document to admit up to 35 non-accredited investors under Rule 506(b) (note that this option is not available for issuers relying on general solicitation under Rule 506(c)).
The Final Rule includes the following notable revisions:
Revisions Applicable to Individual Accredited Investors
Joint Net Worth and Spousal Equivalents Expanded
For purposes of the $1 million joint net worth requirement under Rule 501(a), the Final Rule adds a note that “joint net worth” represents the aggregate net worth of the investor and his or her “spousal equivalent,” which encompasses any cohabitants occupying a relationship generally equivalent to that of a spouse. The Final provides that an investor relying on the Rule 501(a) joint net worth test does not need to purchase the security jointly.
Certain Licensed Investment Professionals Automatically Qualify
The Final Rule allows an individual with certain investment-related professional certifications, designations or other credentials designated by SEC order to qualify as an accredited investor. The following designated individuals who possess the following professional certifications are considered qualified accredited investors:
- Licensed General Securities Representative (Series 7);
- Licensed Investment Adviser Representative (Series 65); and
- Licensed Private Securities Offerings Representative (Series 82).
Additionally, the Final Rule provides a non-exhaustive list of factors for the SEC to consider in issuing additional orders to include a designation, including whether: (1) the credential arises out of examinations administered by a self-regulatory organization or educational institution; (2) such examinations are reasonably designed to demonstrate an individual’s knowledge with respect to securities and investing; (3) the person with the credential can reasonably be expected to have sufficient knowledge to evaluate prospective investments; and (4) the credential is made publicly available. Further, the individual is required to maintain such credentials in good standing, if applicable.
Knowledgeable Employees of Private Funds Deemed Accredited Investors
With respect to an investment in a private fund, the Final Rule adds a new category of accredited investor for individuals who qualify as “knowledgeable employees” of the fund as defined in Rule 3c-5(a)(4) under the Investment Company Act of 1940 (Investment Company Act). Under the Investment Company Act, knowledgeable employees are permitted to invest in private funds without affecting the fund’s eligibility for the exclusions from the definition of “investment company” under Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act. Knowledgeable employees of a private fund generally include executive officers, directors, trustees, general partners or persons serving in a similar capacity with respect to the fund or its manager and employees of the private fund or its manager (other than employees performing solely clerical, secretarial or administrative functions) who, in connection with their regular functions, have participated in the investment activities of such private fund or other funds managed by the same or an affiliated manager for at least 12 months.
Revisions Applicable to Entities qualifying as Accredited Investors
Entities by type.
The Final Rule broadens the types of entities that qualify as accredited investors to include by definition entities (regardless of whether they satisfy the $5 million total asset threshold for entities generally) that are:
- registered with the SEC or a state securities authority as an investment adviser, or that file reports with the SEC as an exempt reporting adviser; or
- rural business investment companies (RBICs).
The Final Rule also codifies the longstanding position of the SEC staff that limited liability companies that have not been formed for the purpose of making the investment and that have total assets in excess of $5 million qualify as an accredited investor.
Catchall for entities with at least $5 million in investments.
The Final Rule also add a new category of accredited investor to capture any type of entity owning “investments” in excess of $5 million and that is not formed for the specific purpose of investing in the securities offered. This new catch-all category covers existing types of entities not specifically enumerated in the definition such as Indian tribes, labor unions, governmental bodies and funds, and foreign entities, as well as entity forms that may be created in the future.
- All equity owners look-through. Under the existing rule, an entity qualifies as an accredited investor if all of the equity owners of that entity are accredited investors. This particular amendment adds a note to clarify that it is permissible to look through multiple layers of equity ownership of an entity to natural persons to determine whether all of the equity owners of that entity are accredited investors.
- Family offices. The Final Rule adds new categories of accredited investors for (i) “family offices” as defined in Rule 202(a)(11)(G)-1 under the Investment Advisers Act of 1940 (a) with at least $5 million in assets under management, (b) that are not formed for the specific purpose of acquiring the securities offered and (c) whose investment is directed by a person who has such knowledge and experience in financial and business matters that such family office is capable of evaluating the merits and risks of the prospective investment; and (ii) “family clients,” as defined in Rule 202(a)(11)(G)-1, of a family office meeting the criteria specified above.
- QIBs. The amendment also expands the qualified institutional buyer exemption under Rule 144A by adding RBICs to Rule 144A(a)(1)(i)(C) and limited liability companies to Rule 144(a)(1)(i)(H). The Final Rule also add a new provision to ensure that entities that qualify for accredited investor status also qualify for qualified institutional buyer status when they meet the $100 million in securities owned and invested threshold in Rule 144(a)(1)(i).
What are the practical considerations of the Final Rule
The Final Rule will become effective 60 days following formal publication in the Federal Register, which means the Final Rule will begin applying to securities offerings in early November. The Final Rule does not alter the SEC’s existing requirements for how issuers must determine whether investors satisfy the accredited investor criteria, which vary based on which category of Regulation D under which the issuer claims exemption. However, with the implementation of the Final Rule the SEC effectively expands the pool of eligible investors for all types of issuers, including start-ups, real estate syndications, real estate funds and other funds such angel capital and venture capital.
Because of how the wide use of Regulation D offerings by various types of issuers, the Final Rule will have considerably impact on many private securities offerings. If you would like further information about the Final Rule, please contact one of the authors.
Coni Rathbone and Jason Powell are attorneys at Dunn Carney LLP, which recently opened an office in Eagle. Dunn Carney advises businesses and individuals in real estate, Opportunity Zones, business, tax and securities matters, as well as litigation, and estate planning and administration.